One of the most important aspects of the business of innovative, fast-growing, i.e. start-up companies is the provision of financing through the so-called “raising of investments” from external sources – business incubators and accelerators, investors – business angels and venture capital funds – VC funds, which in return expect a share in the company. .
In the process of raising investment, start-up companies often neglect legal aspects.
First of all, I want to present a brief overview of the investment process in order to highlight the stages in which legal issues are raised as one of the central ones.
Stages in the investment process
Preliminary contacts: The first and completely informal phase of the investment process during which they get to know each other and assess their mutual compatibility. From the point of view of a start-up, the ideal investor, in addition to money, should bring knowledge, experience and contacts.
Negotiations: Negotiations are often conducted with one investor who requires exclusivity. During the negotiations, the transaction terms are defined, which are stated in the Term Sheet and checked through Due Diligence.
Term Sheet and Due Diligence: Although formally non-binding, the Term Sheet sets the framework of the transaction that rarely changes, so it is important to be careful about what is signed. The term sheet defines a detailed description of the transaction framework and all essential elements of the agreement between the company and the investor (amount of investment, value of startup capital, form of investment, expected shares, relations between the founder and the investor, etc.). The Due Diligence process requires a detailed check of the legal, financial, and technological state of the start-up. The process is faster and easier if the start-up is ready, i.e. it has quality and neat documentation. The main areas of legal review are intellectual property rights, corporate structure, relations between members, labor relations and contracts with key suppliers and customers.
Preparation of investment documentation: A very complex set of documents, written in professional language, in which all elements from the Term Sheet are elaborated in detail, certain guarantees are given and sanctions are defined for possible violations of the contract. One of the most important documents is the Shareholder Agreement by which two or more members of the same company regulate issues of importance for their mutual relations in relation to the company, such as: specific rights and obligations of the member in connection with the transfer of shares, agreements on how to vote in the assembly, mechanisms for solving the blockage in decision-making, etc.
The focus of this text will be on the stages of the investment process from the formal start of negotiations to the signing of the Term Sheet and preparation for Due Diligence, as well as specific things that start-ups should take care of in order to protect their interests.
The most important aspects that start-up should consider
Legal documentation and compliance: Start-up companies, like all other companies, should keep in mind that orderly and harmonized legal documentation will greatly facilitate their business, and consequently, negotiations with potential investors. The founders are, understandably, focused on product development and often neglect the administrative part of the business. The best starting point is a well-defined corporate structure and regulated relations between the founders. In particular, care should be taken to ensure that the company’s intellectual property is adequately protected, that the company does not endanger intellectual property of other, that is, that it has adequate licenses for all the software it uses. Then, it is important that labor relations are properly regulated, especially in terms of intellectual property and non-competition. Compliance with sectoral regulations should not be neglected if the company operates in sectors that are specifically regulated such as the financial sector (FinTech) or medical technologies (MedTech). Also, the processing and protection of personal data is particularly important from the point of compliance. Investors appreciate when they negotiate with a company that has proper and compliant legal documentation, as this reduces future costs and enables faster growth.
Exclusivity: Investors often ask for exclusivity in negotiations, that is, for a specific investor to be the only one with whom they negotiate in a certain period of time. Founders are advised not to agree to too long periods of exclusivity in order not to be “trapped” in negotiations with one investor in case it becomes clear that an adequate agreement will not be reached.
Shares: When negotiating an investment, one of the central topics is the valuation of the company, which is dealt with by financial experts, and consequently the monetary value of the investment and the percentage of ownership that will be transferred to the investor. It is very important to correctly define shares in the ownership of the company’s share capital, because they determine the rights of the company’s members, i.e. the founders and investors. Also, it is very important not to transfer too large a share of ownership to investors in the early stages of development in order not to block financing in later stages. It is important to define the purpose of the investment funds, as well as the terms in which the funds will be paid to the company.
Balance of power: Founders should pay particular attention when defining the required majority for making certain decisions, especially if they deviate from those specified by the Law on Companies. The most important decisions are taken by a two-thirds majority and unanimously. Investors often request the right of veto for making certain decisions, which means that their vote is necessary for making a specific decision. The recommendation to the founders is to keep the circle of such decisions as narrow as possible. Also, investors sometimes insist that one or more directors of the company be from among the investors, and the founders should negotiate such a provision with special caution. Founders should also be familiar with the right of pre-emption, drag along and tag along clauses, as well as call and put options. All the mentioned clauses are ways to balance the power between founders and investors so that any disagreements have as little impact on the development and functioning of the start-up as possible.
Vesting: Vesting represents a time period or the achievement of certain results that must be achieved in order for the founder to acquire the right to compensation for his share in the event of withdrawal from the company. The more common type of vesting is related to the passage of time and the usual terms are from 36 to 48 months.
Warranties and indemnification: Last, but not least, the topic is the guarantees that founders provide to investors for the information presented during the Due Diligence process. It is most important for the founders to guarantee only the information they are sure of, which is why good preparation for negotiations with investors is crucial both for the success of the negotiations and for the protection of the interests of the founders and the start-up company itself.
This text aims to introduce founders and future founders to some of the most important aspects of negotiations with potential investors. Successful management of legal aspects during the investment process can significantly contribute to the long-term success of a start-up company, enabling focus on product development and business growth with minimal legal risks.